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Recursive Utility, Endogenous Growth, and the Welfare Cost of Volatility

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  • Anne Epaulard

    (IMF Institute)

  • Aude Pommeret

    (Universite de Lausanne)

Abstract

This paper proposes a measure of the welfare cost of volatility derived from a stochastic endogenous growth model extended to the case of a recursive utility function which disentangles risk aversion from intertemporal elasticity of substitution. The measure of the welfare cost of volatility takes into account not only the direct effect of volatility on expected utility but also the link between volatility and growth. It thus encompasses a direct welfare cost of fluctuations and a welfare cost due to the endogeneity of the consumption. We obtain a closed form solution for these two costs and show that the total welfare cost of volatility increases with both the risk aversion and the intertemporal elasticity of substitution. For plausible values of the agent's preference parameters, the cost of volatility may be greater than measures based on an exogenous process for consumption. However, when applied to the US economy, our measure shows little differences compared to the one derived under the assumption that the consumption process is exogenous. Yet, we show that this may not be the case for more volatile economies. (Copyright: Elsevier)

Suggested Citation

  • Anne Epaulard & Aude Pommeret, 2003. "Recursive Utility, Endogenous Growth, and the Welfare Cost of Volatility," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(3), pages 672-684, July.
    • Handle: RePEc:red:issued:v:6:y:2003:i:3:p:672-684
    DOI: 10.1016/S1094-2025(03)00016-4
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    More about this item

    Keywords

    welfare costs of fluctuations; recursive utility; endogenous growth; risk;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E60 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - General

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